S-Corporation Designation

Last year, I mentioned my accountant saved me $15,000 by re-classifying my self-employment income from a limited liability corporation (LLC) to an S-corporation. I glossed over the process; in fact, getting to the $15,000 in tax savings was a bit more complicated than simply filing as an S-corporation. I could likely have saved even more if it hadn’t been too late to re-classify prior years, as well, or if I had worked with an accountant from the beginning.

I’ll share some details now so that readers — those with self-employment income, whether from a blog or otherwise — can determine whether this is the right choice for them. Keep in mind I am not an accountant or tax professional. Always discuss your particular situation with a tax accountant who will help you come to the right decisions.

An S-corporation is a type of legal business entity that, like LLCs or partnerships, allow all income or losses from a business to be passed along to shareholders and included in personal income tax returns. The biggest benefit, unlike LLCs or partnerships, is that not all business income needs to be passed to the owners as salary or wages.

For example, if you are the only shareholder, you could assign yourself a reasonable salary. You would owe self-employment tax on only this salary, not on your full business income. The remainder of your business profit will still be added to your personal income. You will owe income taxes on the full profit of the business, but only owe additional self-employment tax on the amount you designate as salary.

There are a few disadvantages for filing your business taxes as an S-corporation. The amount of necessary paperwork increases. If you’re busy running your business, you may not have time to deal with this. I’m glad I have a tax accountant to advise me and handle the paperwork. Considering the amount of money I saved, he has been worth his fee.

Filing as an S-corporation may make you more vulnerable to IRS audits, so ensure you’ve fully documented your income and deductions.

To create an S-corporation, complete your state’s process for incorporation and acquire a federal tax identification number. If you’ve already incorporated, or if you’ve formed an LLC, you do not need to re-incorporate, but ensure your state’s rules for your entity type meet your needs. File IRS form 2553 to elect S-corporation status.

When you file your taxes each year, rather than completing the form 1040 Schedule C, use form 1120S and Schedule K-1. Form 1120S is due before personal income taxes, so ensure your documentation has been sent in, or your extension request has been filed, by March 15 every year. Don’t forget to check your state filing requirements, too.

Just as a point of clarification, you made a statement which is not accurate. You said the following:

“The biggest benefit, unlike LLCs or partnerships, is that not all business income needs to be passed to the owners.”

I think the following sentences kind of cleaned it up, and I suspect what you meant to say was not all business income needs to be passed to owners AS SALARY. And that is the key difference. How the income is passed through not if it is passed through.

The only entity that keeps income from passing through and becoming taxable to the individual owners is a C-Corporation (which is what publicly traded companies are).

S-corp, LLC, LLP, partnership, sole proprietorship, etc, all pass 100% of all business profit on to the individuals as taxable income. The LLC passes it on as wages, the S-corp passes it on (on the K-1) as business income. The difference is that wages are earned income which is taxable for payroll taxes (social security and medicare) and business income is unearned income which is not taxable for payroll taxes. And of course this is a big distinction because for a self employed business owner there is no other employer to pay the other half so you pay 15.3% for that tax.

As you said the S-corp requires you to pay yourself a salary as you are not allowed to work for the s-corp for free and take no earned income and thus fully escape payroll taxes. And as you said the IRS allows you to pay yourself a REASONABLE salary. Plenty of people take advantage of what is reasonable and pay themselves what too small of a salary to avoid the payroll taxes, but in the end if the IRS audits you they will decide if they think your salary was reasonable or not.

I have had multiple people who think the proper corporate structure allows profits to sit in the company and not get taxed, so I just want to make sure the point is clearly state: There is no way to not pay taxes on profits. If the profit is not spend on a business expense it is taxed. Period! The corporate structure can change how it is classified for tax purposes but it is all going to get taxed.

I have had accountants (good ones who are interested in following the law not skirting it) suggest that the most defensible test is what would you have to pay to hire someone else to do the job you do. If you can find comparable jobs and show that you are paying yourself a similar wage then that should be easy to defend against an IRS challenge. If you don’t put in full time type hours for this business then a part time adjustment would seem appropriate.

If you’ve already structured your business as an LLC, you can always remain an LLC and elect to be taxed as an S-Corp. It’s a fairly simple change and in many cases may be the best choice for small business owners.

Nice post, Flexo. I’m structured as an LLC but will file under the S-Corp designation as well. It was very easy to set this up in Texas: $300 for the LLC to the State, then a Form 2553 to the IRS to claim the S Corp status. Come tax time I may need some help though.

If you organize as an LLC but opt to be taxed as an S-Corp, do the lighter LLC documentation requirements still apply? Or would my paperwork increase substantially? I know I’d need an additional K-1, but is there anything else?

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